Azerbaijan Economy and the Oil Prices: a Blessing in Disguise?

International crude oil prices, which have hovered at $110 per barrel for the last three and a half years, started a sudden and abrupt downfall in August 2014, reaching a $50 per barrel mark in just five months. More than a year after the event, it looks like the oil price of $50 per barrel is here to stay, at least for the foreseeable future.

BLAME THE TECHNOLOGY

The primary reason behind the drop was undoubtedly the technological advances in shale oil and gas extraction in the United States – a boom so big, that the US is now poised to become a net energy exporter.

Unlike the gas market with its long-term contracts, the crude oil market is very sensitive to supply side changes.

In 2014, the U.S. increased its oil production by 15.9%, which accounted for 12.3% of the world’s total crude oil extraction. As a result of the “supply glut” and weaker-than-expected demand from China (the world’s fastest growing emerging market), oil prices started to fall instantaneously, quickly reaching the levels not seen since 2005.

Moreover, the world’s largest oil producers, members of the Organization of Petroleum Exporting Countries (OPEC), decided not to reduce their supply. Undoubtedly, they hope that by maintaining production at the current level, they will be able retain their collective market share while at the same time driving the shale oil rivals out of the market. This may be a reasonable strategy, given that the shale oil extraction method is still quite expensive, requiring high prices to deliver reasonable profit margins, and that OPEC’s key player, Saudi Arabia, has huge reserves of cheap oil to overcome the impact of the price drop.

AZERBAIJANI ECONOMY TAKES A HIT

Changes in the petroleum market resonated throughout the world, but they especially impacted the oil-exporting countries. Azerbaijan can be justly proud of its world’s oldest oil wells, however, with a market share of just 1% of global production, it cannot really hope to influence the price of crude.

Therefore, when “black gold” prices sharply decreased, Azerbaijan had to go with the flow of events, which had important economic consequences for its economy. The price drop not only decreased exports (see graph below) and government revenues (which declined by 15.4% in the first 6 months of 2015 relative to 2014), but directly impacted Azerbaijan’s national currency, the value of which had been until then fixed to the US dollar.

Lower oil prices lead to the decline of dollar inflows into the Azerbaijani economy. This, coupled with the general trend of USD appreciation against all major currencies, left Azerbaijan with little choice but to devalue the manat in February 2015 by a third of its value. Prior to that, the country’s Central Bank burnt a substantial chunk of its foreign exchange reserves trying, in vain, to sustain the peg.

CAN THE OIL SECTOR DECLINE BECOME A BOON FOR OTHER SECTORS?

Oil and gas account for about 40% of Azerbaijan’s GDP. The largest non-oil GDP contributor (13.4% in 2015), the construction sector, is almost totally dominated by state infrastructure projects. The large share of construction activities is partially explained by the fact that Azerbaijan had undertaken ambitious infrastructure projects while preparing for the First European Games in June 2015. It would be quite natural to expect public construction spending (and the sector) to shrink as oil and gas revenues decline.

Construction is followed in importance by the wholesale and retail trade (9.9% in GDP) and agriculture (6.3%). Agriculture is particularly important as it accounts for about 38% of the country’s total employment. Its competitiveness, however, had suffered for years from the effects of the so-called “Dutch disease”. As long as high oil prices propped the value of the manat against other regional currencies, the domestically produced agricultural goods could not compete against the cheaper Turkish and Georgian produce (except with the help of “non-tariff” barriers to trade, which Azerbaijan has used quite extensively in order to “outcompete” more efficient producers).

Now, a weaker manat is very good news for Azerbaijani farmers. Growth in agriculture amounted to 7.4% in the first 6 months of 2015, in contrast to the previous year, when the sector experienced a decline of 3.4%. The effect of oil prices on the wholesale and retail trade sector is more ambiguous. The trade sector may not benefit so much from manat devaluation, as one can expect domestic demand to decline for both imported and domestically produced goods.

OIL PRICE EFFECT ON THE REST OF THE CAUCASUS

Low oil prices are, of course, a boon for oil importing countries, such as Georgia. In fact, Georgia has already seen a significant decline in its transportation costs (in which the cost of fuel is a very large component). At the same time, Georgia is adversely affected by weaker demand for its products on the Azerbaijani market.

First and foremost, Baku is one of Georgia’s main trade partners: around 12% of Georgian export goes to Azerbaijan. Second, in the last couple of years Azerbaijan has become a top supplier of tourists to Georgia, bringing much needed revenue and opportunities for employment. Thus, the expected decline in Georgian exports to Azerbaijan and the number of Azeri visitors will negatively affect Georgian businesses as well as low-skilled, self-employed workers, and people employed informally in a wide range of sectors: from food and clothes retail to second-hand cars.

THE STATE OIL FUND OF AZERBAIJAN AND ITS ROLE

Considering that oil and gas are depletable resources, the government of Azerbaijan created a special fund (the State Oil Fund of Azerbaijan, SOFAZ) the main goal of which is to accumulate and efficiently manage oil revenues. One area in which SOFAZ is supposed to be particularly active is development of the non-oil sectors. Thus, one would expect that dwindling oil revenues will have an negative effect on SOFAZ’s overall budget and its efforts to stimulate the non-oil sector.

Will this forestall the revival of the non-oil sector in Azerbaijan? So far, the data seem to indicate otherwise.

Despite the difficulties created by the fall in the world oil price – the fall in export volumes, budget revenues, and the currency's value – Azerbaijan’s Statistics Office reported positive GDP growth in first six months of 2015. Compared to the same period of the previous year (January-August 2014), GDP as a whole grew by 4.2% (compared to 2.4% last year), while the non-oil sector grew by 7.3% (compared to 6.3% last year).

If this trend continues, the fall in the price of “black gold” may indeed prove to be a blessing in disguise for Azerbaijan.

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